Heirs Not Liable for Estate's Taxes as Trustees or as Personal Representatives

(Parker Tax Publishing December 2016)

A district court determined that two of a decedent's heirs, who were also personal representatives of her estate and successor trustees to a family trust included in the estate, were not liable for delinquent estate taxes. The court determined that the trust's assets were included in the estate under Code Sec. 2033, and thus the taxpayers weren't liable as trustees. The court also held that the taxpayers had filed a valid Code Sec. 6423A special lien on the trust's assets, and thus they weren't liable as personal representatives. U.S. v. Johnson, 2016 PTC 502 (D. Utah. 2016).

Background

Anna Smith died testate on September 2, 1991. She was survived by her four children, whom she named as her heirs. Before her death, the decedent executed a will and established the Anna Smith Family Trust. The Trust was funded by 11,466 shares of stock in State Line Hotel, Inc. (the Hotel). During her life, Anna had an unlimited power to modify, alter, amend, revoke, or terminate the trust, and, as grantor, she had the right to withdraw principal and income from the trust as she directed. The trust agreement named two of her children, Mary Johnson and James Smith, as successor trustees. Johnson and Smith were also named in the decedent's will as personal representatives of her estate.

As directed by the trust agreement, the successor trustees filed a federal estate tax return with the IRS on June 1, 1992. The decedent's gross estate was valued on the return at nearly $16 million, resulting in a federal estate tax liability of approximately $6.6 million, of which $4 million was paid at the time of filing. The majority of the decedent's gross estate consisted of 9,994 shares of stock in the Hotel, valued by a valuation expert on the return at $11.5 million. Because the Hotel was a closely held business and its value constituted more than 35 percent of the decedent's adjusted gross estate, Johnson and Smith elected to defer payment of the remainder of the federal estate tax liability pursuant to Code Sec. 6166(a), which provided that the remaining balance of the tax liability would be deferred for five years, at which time the successor trustees would pay it in ten annual installments beginning in June 1997 and ending in June 2006.

In May 1997, about a week before the due date of the first estate tax installment payment, Colleen Girard, an agent from the IRS, sent a letter to Johnson in her capacity as executor of the estate, informing her of alternatives to her personal liability for the unpaid estate tax deferred under Code Sec. 6166. One of the alternatives offered was for Johnson to furnish a Special Lien for Estate Tax Deferred Under Section 6166, as described in Code Sec. 6324A. After obtaining additional information regarding the special lien, Johnson and Smith provided the IRS with an executed Agreement to Special Lien Under Section 6324A signed by all four children of the decedent and an agreement restricting the sale of the Hotel stock while the lien on the stock was in effect.

In January 2002, the Hotel filed for Chapter 11 bankruptcy. By May 2002, the bankruptcy court approved the sale of all Hotel assets free of liens, claims, and encumbrances. A year after the conclusion of the Hotel bankruptcy, the IRS sent Smith and Johnson delinquent billing notices for the outstanding estate taxes. The notices informed them that if they defaulted, the entire balance of the estate taxes would be due immediately.

In 2003, the estate defaulted on its federal estate tax liability, after having paid $5 million of the total amount due. In 2011, the IRS instituted a suit in district court in an attempt to collect the outstanding estate tax liability from the estate's heirs as transferees and from Johnson and Smith as the estate's personal representatives. The court, in U.S. v. Johnson, 2012 PTC 131 (D. Utah 2012), dismissed the IRS's claims that each heir should be individually liable for the unpaid estate taxes as a transferee of the trust assets pursuant to Code Sec. 6324(a)(2), but determined that Johnson and Smith, as personal representatives, may have individual fiduciary liability for the estate taxes under 31 U.S.C. Sec. 3713. The court also determined that Johnson and Smith, as successor trustees, were personally liable for the estate tax because the Trust assets were included in the decedent's gross estate under Code Sec. 2036(a). Johnson and Smith challenged that ruling, and also argued that they should be discharged from personal liability under 31 U.S.C. Sec. 3713 as a result of satisfying the requirements for a special lien pursuant to Code Sec. 6324A and thus obtaining a discharge pursuant to Code Sec. 2204.

District Court Determines It Erred; Taxpayers Not Liable as Trustees

The district court noted that as successor trustees of the Trust, Johnson and Smith could be personally liable for unpaid estate taxes up to the value of the Trust assets under Code Sec. 6324(a)(2) only if the Trust assets were included in decedent's gross estate under Code Secs. 2034 to 2042, inclusive. Johnson and Smith argued that the decedent's assets were included in her estate under Code Sec. 2033 because she retained full beneficial ownership of all Trust assets during her lifetime and there was no transfer to any other Trust beneficiary until the time of her death. By contrast, the IRS argued that the decedent's assets were either included in her estate under Code Sec. 2036(a) because they were transfers with a retained life estate, or under Code Sec. 2038 because she retained the power to alter, amend, revoke, or terminate the Trust.

The court initially concluded that the assets in the Trust, a fully revocable grantor trust, were included in the decedent's gross estate under Code Sec. 2036(a)(2) because as a result of the creation of the Trust and the designation of the beneficiaries therein, at the instant of death, the beneficiaries had a legally enforceable interest in the Trust property. Johnson and Smith requested that the court reconsider its decision, arguing that the critical question for their claim that the Trust assets were included in the gross estate under Code Sec. 2033 was not whether the beneficiaries obtained a legally enforceable interest at the moment of the decedent's death, but rather what interest the decedent herself held at the moment of her death.

Upon reconsideration, the court held that its original ruling erred in determining that the specific language of Code Sec. 2036 was broad enough to make the decedent's creation of the Trust and transfer of legal title from the decedent as grantor to the decedent as trustee a "transfer" for estate tax purposes. The court stated it also erred in determining that at the "instant of death" the beneficiaries had a legally enforceable interest such that Trust assets were properly includable in the estate pursuant to Code Sec. 2036. Upon reconsideration, the court found that the Trust assets were never "given away" such that the decedent lost the beneficial ownership of them during her lifetime, and thus that there was no transfer - incomplete or not - for purposes of Code Secs. 2036 and 2038 prior to her death. As a result, the court concluded that Trust assets were included in the gross estate pursuant to Code Sec. 2033, which precluded Smith and Johnson's liability as trustees for the estate tax under Code Sec. 6324.

Having determined that Smith and Johnson were not personally liable for the unpaid estate taxes in their capacities as trustees of the estate, the court then turned to the question of whether they were liable in their capacities as personal representatives of the estate. The court noted that the IRS's claim for 31 U.S.C. Sec. 3713 liability would be rendered moot if it determined that Smith and Johnson's personal liability was discharged under Code Sec. 2204 as a result of furnishing a valid Code Sec. 6324A special lien.

Code Sec. 2204(a), the court said, provides a general rule that allows personal representatives of an estate to be discharged from personal liability for unpaid federal estate tax by either paying the estate tax owed, or, in the case of assessed tax payments deferred under Code Sec. 6166, by furnishing a valid special lien agreement under Code Sec. 6324A. The court noted that when a personal representative elects to defer estate tax payments under Code Sec. 6166, he or she can furnish a special lien under Code Sec. 6324A on certain property in favor of the IRS, and if the three requirements in Reg. Sec. 301.6324A-1 are met, the IRS must accept the special lien and the deferred amount is considered a lien in favor of the IRS on the Code Sec. 6166 lien property.

The first requirement, the court observed, is for the personal representative to make an election by applying to the IRS office where the estate tax is filed before the tax and interest are paid in full. The court noted that the taxpayers timely made a notice of election requesting the special lien, and determined the first requirement was met. The second requirement, the court stated, is for the personal representative to file a proper agreement that contains, among other things, signatures by all parties having an interest in the property, the amount of the lien, and the fair market value of the property. The court found it undisputed that the Agreement to Special Lien Under IRC Section 6324A filed by the taxpayers met the second requirement.

The third and final requirement, the court said, is that the Code Sec. 6166 lien property (i.e. the collateral) be an interest "in real and other property to the extent such interests can be expected to survive the deferral period, and are designated in the agreement." The court noted that while the IRS did not dispute that the Hotel stock was properly designated in the agreement, it disputed whether the stock was expected to survive the deferral period and whether its value was sufficient.

The IRS, the court said, disputed the report of the taxpayers' expert as to the history of the business and his claim that the Hotel had been in operation for decades without interruption or financial stress, which supported the survivability of its stock. However, the court observed, the IRS's own expert report did not set forth any specific facts suggesting that the Hotel's financial stability or history were not as represented, and determined the IRS did not adequately prove the taxpayers failed to meet the survivability requirement.

The court stated that the IRS's dispute over whether the value of the Hotel stock was sufficient was nonmaterial, noting that Code Sec. 6324A does not require a minimum value to be met for a special lien to arise. If the value of lien property is too low, the court remarked, it does not mean that the special lien did not arise, it just means that the IRS is under-secured. The court noted the IRS's remedy for insufficient value to secure deferred tax obligations is to accept a bond in the amount of the shortfall, or to require the addition of property to the special lien agreement. The court stated that rather than making such specific requests, the IRS instead purported to reject the Hotel stock as collateral, but, because Code Sec. 6324A is a taxpayer election, nothing in the statute authorized the government to reject the election.

Accordingly, the district court determined that the three requirements for a valid special lien under Code Sec. 6324A were met, and that consequently, Johnson and Smith's fiduciary liability as personal representatives of the Estate for the unpaid estate tax were discharged as a matter of law and the IRS' claim for fiduciary liability under 31 U.S.C. Sec. 3713 was moot.

For a discussion of the special estate tax lien, see Parker Tax ¶228,940.10.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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